• Strategy
  • The Economist

Places in the Sun

Offshore financial centres are booming, thanks to their easy-going tax regimes. But the best of them are more than tax havens: they are good for the global financial system.

If the deal over North Korea’s nuclear-weapons programme holds, Kim Jong Il may be able to indulge his penchant for fine wines and Hollywood blockbusters again. Banks around the world had severed ties with North Korea after America last September blacklisted a Macau bank accused of doing business with the hermit kingdom, making foreign money tighter for the Great Leader. But a move towards more normal relations with America could help restore the flow.

The financial system is modern warfare’s newest front. In a globalised economy money moves instantly and anonymously across borders. This can benefit terrorists, drug traffickers and rogue nations in need of cash. Keeping such customers out of the world’s sprawling financial system is becoming ever harder.

Financial regulators have another big concern. Footloose capital transmits not just tainted money but financial crises too. The huge growth in the use of esoteric derivatives and the rise of hedge funds have made it increasingly difficult to understand where financial risk lies, partly because much of it is hidden away on islands with variable supervision.

But the most vexing problem that highly mobile financial flows pose for governments is that when they cross borders they may take tax revenues with them. This is particularly serious for rich Western countries with ageing populations that they will have to support in retirement. Such countries have launched a raft of initiatives to strengthen the international financial system against the undesirable side-effects of financial globalisation: financial crime, financial contagion and tax evasion. The idea is to prod financial centres worldwide to adopt international best practice on bank supervision, the collection of financial information and the enforcement of money-laundering rules.

One group has become the object of special scrutiny: offshore financial centres (OFCs). These are typically small jurisdictions, such as Macau, Bermuda, Liechtenstein or Guernsey, that make their living mainly by attracting overseas financial capital. What they offer foreign businesses and well-heeled individuals is low or no taxes, political stability, business-friendly regulation and laws, and above all discretion. Big, rich countries see OFCs as the weak link in the global financial chain.

In the past OFCs have indeed permitted various dodgy doings. Critics think their dependence on foreign capital encourages them to turn a blind eye to crime and corporate fraud within their borders. Sani Abacha of Nigeria, Mohammed Suharto of Indonesia and Ferdinand Marcos of the Philippines are just a few of the corrupt leaders who have looted their countries, helped by the secrecy offered not just by certain tax havens but also by some onshore financial centres, a point often ignored by the OFCs’ critics. Some of the money used for the terrorist attacks of September 11th 2001 was funnelled through Dubai, which has recently set itself up as a financial centre. The accounting scams at Enron, Parmalat and Tyco were made easier by complicated financial structures based in OFCs (though, again, also in onshore centres such as Delaware).

Tax Wars

But the most obvious use of OFCs is to avoid taxes. Many successful offshore jurisdictions keep on the right side of the law, and many of the world’s richest people and its biggest and most reputable companies use them quite legally to minimise their tax liability. But the onshore world takes a hostile view of them. Offshore tax havens have “declared economic war on honest US taxpayers”, says Carl Levin, an American senator. He points to a study suggesting that America loses up to $70 billion a year to tax havens.
The Tax Justice Network, a not-for-profit group that is harshly critical of OFCs, reckons that global tax revenues lost to OFCs exceed $255 billion a year, although not everybody believes it. Canadians were alarmed by a government report showing that Canadian direct investment in OFCs increased eightfold between 1990 and 2003, to C$88 billion ($75 billion) — a fifth of all Canadian direct investment abroad. The bulk of this was in financial services, mostly in a few Caribbean countries.

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